Expert Commentary: The Latest Rally Has Come To An End

• WTI breached our $38/$48 forecast this week as supply disruptions in Nigeria, Latin American and Africa (estimated by Morgan Stanley to be ~2m bpd in total) took center stage. Seeing technical strength in the current rally but fair value for oil in the mid $40s, we continue to wait for a move above $50 to get short flat price. Our bearish view of a +$50 WTI scenario is based on 1.) record inventory gluts at storage hubs from Cushing to Rotterdam exacerbated by supply gains from core OPEC members and improved hedging opportunities for U.S. producers 2.) demand risks of decreased Chinese stockpiling as prices increase and poor global refining margins 3.) waning bullish sentiment as evidenced by recent COT and USO data and 4.) potential for more USD strength with a June rate hike possible. Lastly, we aren’t impressed with a market that can’t aggressively punch through the $50 mark- or move spreads near backwardation- with help from such substantial supply outages.

• Canada’s wildfires disrupted output by more than expected this week and pushed the prompt 1-month WTI spread to a contango of just 48 cents. The median estimate for lost Canadian barrels we are seeing is still about 1m bpd. U.S. production dropped for a ninth straight week and rigs fell for the 20th time in the last 21 weeks. However, Cushing stocks and overall U.S. inventories both built to new record-highs with help from a flood of imports into the U.S. Gulf Coast. Overseas, Libya’s Hariga port loaded a 650k bbl tanker for the first time since April following the completion of a deal between Tripoli and eastern Libyans. Unfortunately, mayhem in Nigeria continues to build and analysts believe that disruptions have decreased output to somewhere between 1m and 1.4m bpd after pumping 1.7m bpd in April and 2.1m bpd in January.

• The USD was extremely strong this week and odds have increased from 4 percent to 26 percent (as measured by Fed funds futures) that the Fed will hike rates in June. The EUR/USD and WTI have recently lost some of their correlation, but increased FX volatility could easily spill into commodities and regain influence over WTI and brent.

Inventory glut keeps spreads in check despite production issues

Prompt WTI spreads were strong to begin the week as wildfires in Canada proved more disruptive than originally forecast. In some areas rig workers returned to their facilities only to be evacuated once again after the fires unexpectedly spread and the disruption continues to cost the market about 1m bpd of oil. As of Thursday, only Shell and Statoil had restarted oil sands production and at very limited rates. U.S. production data was also bullish for spreads as U.S. crude output hit its lowest level since September ’14 at 8.79m bpd while the U.S. oil rig count fell for the 20th time in 21 weeks this year. In the front spread, M16/N16 moved from last week’s low of -0.82 to a weekly high of -0.48 while N16/Z16 rallied about 50 cents before stopping at its now quintuple top at -2.00. WTI structure received a blow on Wednesday after DOE stats surprised traders with a 3.1m bbl inventory build and a 461k bbl build in Cushing despite the significant aforementioned supply outages. The numbers served as a harsh reminder for bullish-spread positions that U.S. refiners still have ample sourcing opportunities, including 10m bbls of crude in floating storage in the Houston area in addition to PADD III’s record-high inventories. The WTI 4Q16 swap traded above $50 this week which could help drive the current 5yr-high in NYMEX WTI commercial and producer short positions even higher.

Prompt brent spreads moved sharply lower this week despite continued stress in Nigeria as Libya resumed exports at its Hariga terminal for the first time in a month. For Brent N16/Z16 this meant a drop from -1.21 on Monday to a weekly low of -1.98 on Thursday. The prompt 1-month spread dropped from -0.26 to -.55. In West Africa, analysts at Facts Global Energy see Nigerian crude production near 1.4m bpd (down over 600k bpd from January) and have a 3Q16 output forecast for the country of 1.5m bpd(1). Petromatrix suggested (2) that Nigerian output (excluding condensate) might be close to 1m bpd. Nevertheless, a Reuters survey of traders this week suggests that there are 20 June-loaded cargoes from Nigeria still available, 10 June-loaded cargoes available from Angola and 53m bbls of floating storage available between the North Sea and Singapore, giving physical traders plenty of options. Singapore stocks are currently estimated at 48m bbls (a 5yr high) after a 10 percent w/w increase.(3) Reuters data also revealed decreased buying from China with the People’s Republic expected to import 29.5m tonnes in May, down from 32.6m tonnes in April.(4) Looking forward, Citi analysts suggested that Saudi output could reach 11m bpd in the summer after averaging 10.3m bpd in April. Bloomberg estimated that Iranian crude and condensate exports averaged 2.13m bpd through the first half of May after averaging 2.3m bpd in April. Related: Can EVs Save Electric Utilities?

With June rate hike on table, oil and EUR/USD could re-couple

Away from oil markets the most important item of the week was building suspicion that the Fed could actually raise rates at their June 15th meeting after the FOMC’s April minutes revealed more hawkish than expected language and some of the more dovish Fed officials suggested there could be two or more rate hikes in 2016. A common point made by Fed watchers this week was the increased feeling that the recently hawkish jawboning will create credibility issues for the central bank if they don’t hike rates at their next meeting. Markets reacted strongly to the shifting mood with Fed fund futures implying 26 percent odds of a June hike (up from just 4 percent last month,) The DXY rallied back above 94 and the U.S. 2yr yield moved from 0.7 percent to over 0.9 percent. As for crude oil, we believe that further sharp moves in the EUR/USD could begin to the market after several weeks of statistically uncorrelated trading. Seeing a medium term sideways oil market, however, we will most likely view any such FX-driven moves as opportunities to buy weakness or sell strength.

Fund enthusiasm for the rally wanes, producers keep hedging

Managed money is increasingly disinterested in being long on crude oil while the market closes in on $50. USO data has revealed net outflows in ten of the last eleven weeks totaling more than $500m. As for fast money, the last two weeks of COT data revealed a net reduction in length between NYMEX WTI and ICE Brent of 95k contracts- the largest net sell effort since July ’15. Net length in brent has been cut by 15 percent over the last two weeks while net length in WTI has been reduced by 14 percent. Both contracts have seen reductions in gross longs and additions to gross shorts over the last two weeks and last week’s data also included a 31 percent jump in gross short positions for WTI. Meanwhile, producers and merchants have taken advantage of the recent rally by amassing their largest gross short position in NYMEX WTI since 2011 at 549k contracts. None of the above trends look positive for crude oil.

Crude option premiums stay flat despite weaker realized volatility

Option markets remained quiet this week with prompt WTI volatility plodding in the 40 percent area. Options skew also remained consistent with recent pricing with 25 delta puts trading at 43 percent while 25 delta calls implied 40 percent volume. Sideways trading in flat price has lead to a decrease in realized volatility (20-day basis) for prompt crude oil to 33 percent, giving us the largest premium in implied volatility to historical volume since March. Given that relationship, we would currently prefer to express directional ideas via options by selling rather than owning options for short term strategies. Recent strength in EUR/USD volatility and the VIX could also present crude oil traders with good opportunities to sell FX and equity driven crude oil volatility.

DOE stats show more strong demand data, oversupply persists

• Crude oil stocks added 1.3m bbls w/w including builds in PADD III and Cushing after a flood of U.S. imports arrived in the Houston area to help replace missing barrels from Canada. U.S. production fell for a 10th straight week to 8.79m bpd.

• Refiner demand increased by 200k bp, but crack margins remain poor.

• Implied U.S. gasoline demand reached an all-time record which is extremely impressive given where we are on the calendar. However, product gluts remain.

U.S. crude oil inventories added 1.3m bbls w/w and are higher y/y by 12 percent. PADDs I and II declined by 288k bbls combined after imports into both regions slowed. However, PADD III added 1.2m bbls after imports into the region increased by nearly 4.5m bbls w/w. Cushing stocks reached a new all-time high at 68.3m bbls following a 461k bbl build.

Refiner demand increased by 200k bpd w/w to 16.37m bpd and is flat y/y over the last four weeks. Refiner profits remain problematic, however, with the WTI 321 crack trading at just $19/bbl this week. Margins in the Houston area and in Europe also continue to yield multi-year seasonal lows with the LLS 321 crack at $9/bbl and gasoil/brent at $10/bbl. Related: Can Oil Prices Hold Onto Gains At $50 Per Barrel?

Gasoline data was better than expected this week, highlighted by a 644k bbl draw out of PADD IB and a record-high print in implied demand of 10.17m bpd. Overall gasoline stocks reported a draw of 2.5m bbls (+6 percent y/y) with help from a 1.2m bbl draw out of PADD II (+3.4 percent y/y.) PADD III stocks declined by 153k bbls w/w (+9 percent y/y) and PADD IB stocks are higher y/y by 10 percent.

Gasoline futures responded positively to Wednesday’s stats moving above $1.65/gl for the first time since September. The rally completed a 20-cent upswing for RBOB futures since their recent low on May 10th. In spread markets RBOB M16/Z16 hit a weekly top of 23.5 cpg as PADD IB stocks have capped spread strength despite recently strong demand data.

Distillate data was also more bullish than expected including a 3.2m bbl bbl overall draw (+19 percent y/y) and a 947k bbl draw from PADD IB (+62 percent y/y.) PADD II distillates decreased by 735k bbls (-1 percent y/y) and PADD III stocks drew by 1.3m bbls (+20 percent y/y.) Distillate demand had an impressive w/w increase of 312k bpd to 4.33m bpd and is lower y/y by 1 percent over the last four weeks.

Heat futures reacted very positively to the aforementioned unexpected draws and rallied above the $1.50/gl mark (briefly) for the first time since November to cap a 22-cent rally since May 10th. The 1.50/gl mark proved to be a strong resistance line, however, and futures moved back below $1.46/gl on Thursday. Prompt heating oil structure has moved sharply higher since May 13th with M16/Z16 rallying from -10 cpg on May 10th to -6.00 cpd on Thursday.

Gasoil spreads also moved sharply higher this week with M16/Z16 hitting a nearly 1yr high at -12.75 on Wednesday. Gasoil stocks in the ARA hub are 37 percent above their 5yr average following a larger than expected drop this week while Singapore’s inventories are 36 percent above their 5yr average after a larger than expected inventory build.

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